Downside Variance Premium, Firm Fundamentals, and Expected Corporate Bond Returns
41 Pages Posted: 9 Jul 2020 Last revised: 13 Jul 2020
Date Written: June 16, 2020
We find a positive relationship between individual downside variance premia, the difference between risk-neutral and physical expected downside variances, and future corporate bond returns. The hedge portfolio earns the economically substantial and statistically significant excess return of 0.35% (0.39%) per month in value (equal)-weighted returns. The predictive power of downside variance premium is stronger in non-investment-grade (long-maturity) corporate bonds than in investment-grade (short-maturity) ones. We show that downside variance premium positively relates to the likelihood of future default and cash flow uncertainty and negatively relates to future cash flow. When rational investors anticipate a high likelihood of future default, high cash flow uncertainty, or low future cash flow, the current bond price has to decline, resulting in higher future bond returns.
Keywords: Downside variance Premium, Corporate Bond Return Predictability, Equity Options, Probability of Default, Credit Rating Downgrade, Cash Flow Uncertainty
JEL Classification: G10, G12, G14
Suggested Citation: Suggested Citation